Tax Law Note:How Should the Doubtful Debt Reserve Deduction Be Computed?

Legal Department

Last Updated: December 02, 2004

Introduction

Both overdue loans and other trade receivables may be considered bad or doubtful
debt for tax purposes. Bad debt refers to debt whose collection is considered
hopeless, while doubtful debt is debt whose collection is uncertain. Bad debt
is taken off ("charged off") the balance sheet of companies once
it is written off for financial purposes. A tax deduction for bad or doubtful
debt may be allowed either when it is written off for financial accounting
purposes (the charge-off method)1 or
through the creation of tax deductible provisions (the reserve method). A third
alternative is not to allow the deduction of bad debt at all, or to deny the
deduction in certain circumstances. This note refers to a doubtful debt reserve,
but this may also be called a "reserve for bad debts,"2 or
bad debt reserve, namely a reserve set up to provide for the contingency of
debts going bad.

The reserve method requires an accurate estimation of doubtful debt on the
basis of which all or part of the reserve becomes deductible for tax purposes.

This note focuses on the methods of establishing the amount of the tax deduction
for a doubtful debt reserve. The discussion is confined to debts that arise
in the course of a business.

However the amount of the reserve is determined, the mechanics for calculating
the tax deduction for the year are as follows: closing reserve (amount of reserve
at year-end) - opening reserve (amount of reserve at end of prior year) + debts
written off during the year - recoveries of previously written off debts =
deduction for the year.3

One of the methods of establishing the tax deduction for doubtful debt reserves
is to require the taxpayer to perform an appraisal in the case of each individual
account and to determine a reasonable percentage reserve based on the circumstances
of the particular debtor.5

2. General reserve creation rule based on all outstanding debt

Some countries determine the amount of the doubtful debt reserve as a percentage
of all the outstanding accounts receivable. In some countries this percentage
is based on the taxpayer's assessment with respect to the overall ratio of
uncollectible debt and in others the allowable percentage is stipulated in
the law.6

3. General reserve based on age of debt

A third method is classifying outstanding debt claims according to their age
(the time the debt has been in default) and determining the reserve as a percentage
of the outstanding debt. The percentage increases with the age of the debt.7

4. Banks

Due to the nature of their business, banks (and other financial institutions)
usually have relatively accurate methods of establishing the doubtfulness of
a debt or a debt portfolio and are generally bound by regulations issued by
the central bank or other regulatory body with respect to the creation of doubtful
debt reserves. The rules applicable to the tax deduction of bad debt reserves
usually follow the special accounting and financial rules applicable to financial
institutions.8

Fashioning a Solution

Business bad debts are a cost of doing business and so should be allowed as
a deduction. The difficult issue is when the deduction should be allowed -
when the debt becomes worthless and is charged off in the taxpayer's books,
or earlier. The simplest approach is not to allow a deduction for contributions
to bad debt reserves (except in the case of financial institutions). In this
case, the deduction will be delayed until the debt becomes worthless.

What is at stake in fashioning these rules is the time value of money - generally,
taxpayers have an interest in accelerating deductions and the tax administration
has a corresponding interest in delaying them. In addition, the rules on doubtful
debt reserves may give taxpayers some flexibility in timing their income.9

If a country decides to allow a tax deduction related to doubtful debts through
the creation of a deductible reserve, it has two options in practice: either
it can permit setting up reserves based on the risk associated with specific
accounts or it may allow a general deductible bad debt reserve calculated as
a percentage of all outstanding debts. Both approaches present problems in
practice.

Allowing the creation of a general reserve based on the assessment of the
taxpayer may be easy to manipulate by taxpayers and costly and complicated
for the tax authorities to monitor. At the same time setting out in the tax
law or regulations a general percentage of all outstanding debt as a deductible
reserve may not result in a just situation in the case of individual taxpayers.

If greater accuracy is sought by allowing reserve deductions based on the
assessment of specific debts, the conditions under which a debt may be considered
partly or wholly doubtful need to be defined in detail in the tax law or regulations.
Relevant factors could include: the value of any collateral; security for the
debt; financial situation of the debtor (is there a formal bankruptcy procedure
against the debtor?); if the debt is overdue, the time it has been in default;
any legal action required (based on the commercial law rules of the country
in question for collecting receivables). Forming a tax deductible bad debt
reserve may be made contingent on default on payment of the debt, i.e. an addition
to the reserve could only be made possible once the debt is due and enforceable;
having such a provision could significantly limit the possibility of taxpayer
manipulation and would include an objective condition that is easy to control.10

In the case of banks the creation of bad debt reserves is typically obligatory
based on regulations of the central bank or other banking supervisory body.
Setting up such reserves is aimed at minimizing the risks associated with the
banking sector. Therefore the bad debt provisions prescribed by the banking
regulations tend to be conservative to ensure that assets are not overstated.
As a result there is an argument for allowing as the deductible reserve for
tax purposes a smaller amount than the full provision required by banking regulations,
for example, 80-90 percent of the provisions. Whatever the allowed percentage
(e.g., 80% or 100%), defining the tax deduction as a percentage of the addition
to reserves required by the regulators allows the tax authorities to rely on
the regulations issued and audits carried out by the central bank/supervisory
body with respect to the correct calculation of the reserve.

For further reference:

Lee Burns and Richard Krever, Taxation of Income from Business and Investment,
in 2 Tax Law Design and Drafting 629-32 (1998).

The series of Tax Law Notes has been prepared by the IMF staff
as a resource for use by government officials and members of the public. The
notes have not been considered by the IMF Executive Board and, hence, should
not be reported or described as representing the views of the IMF or IMF policy.1There may be additional limitations.
For example, the tax law may require taxpayers to wait until judicial action
to recover the debt has been undertaken and proven fruitless. In some cases,
these rules unduly delay deductions for bad debts.2Treas. Reg. §1.166-4
(United States).3See 2 Tax Law Design and
Drafting 629-632 (1998).4Once the amount of the reserve
is established, a separate problem arises with respect to the annual calculation
of the deductible addition to the reserve. See the table.5In France the provision
for doubtful debts must be based on the taxpayer's assessment of the individual
accounts. CGI 39 1 (5); Code Pratique Fiscal 81-83, Francis Lefebvre, 1999.
The same approach is used in countries such as Belgium, Ireland, and the UK.
IBFD, European Tax Handbook (2001). 6Bulgaria allows the deduction
for tax purposes of 30% of the provisions made by non-financial institutions
and 100% in the case of financial institutions. In Italy reserves are deductible
up to 0.5% of trade receivables not covered by insurance. European Tax Handbook
84, 342 (2001). In the U.S., before repeal of this rule by the Tax Reform act
of 1986, taxpayers were allowed to elect to use a tax deductible general reserve
for bad debts. If so elected, the taxpayer established a reasonable addition
to a reserve for bad debts in lieu of deducting specific bad debt items. What
was considered reasonable was not specifically regulated and was based on the
judgment of the taxpayer. The taxpayer had to file with the tax return a statement
showing - among other related items - the volume of its business transactions
and the percentage of the reserve to such amount. Treas. Reg. § 1.166-4.
The 1986 Act repealed section 166(c), which had allowed this deduction, on the
basis that it allowed an undue acceleration of deductions for bad debts. Currently
in the U.S. bad debts are deductible under section 166 only when actually charged
off.7In Canada the taxpayer has
the option in calculating the doubtful debt reserve to use any of the three
following methods: (1) calculating a percentage of the outstanding accounts;
(2) performing an appraisal of each account; and (3) classifying accounts by
age and increase percentage based on age. Par. 3459, Canadian Master Tax Guide
56th Edition, 2001, CCH Canadian Limited. Czech Republic: general
provision is 20% if debts are overdue more than 6 months, 33% if more than 12
months, 50% if more than 18 months, 66% if more than 24 months, 80% if more
than 30 months and 100% if more than 36 months. Hungary applies the same principle
(2% if debt is overdue for 90-180 days, 5% if 181-360 days, 25% if more than
360 days). European Tax Handbook 142, 284 (2001, IBFD).8In Hungary even though the
general tax rules apply to banks, with respect to establishing the deductible
bad debt reserve special rules apply. In general the reserves are created on
the basis of the age of the debt; however financial institutions have to use
the individual assessment method for determining the reserves. PM Rendelet 14/2001
(III.9.). In Greece a general percentage is set for different groups of receivables
(0.5% of receivables from sale of goods or services, 1% of receivables of commercial
credits and a maximum of 35% of other trade receivables) for ordinary taxpayers,
while special bad debt provisions apply to banks. In Norway banks calculate
their reserves based on the accounting standards applicable to financial institutions
based on banking regulations. European Tax Handbook 259, 434 (2001).9For example, a taxpayer
may want to accelerate income to take advantage of an expiring loss carryover
deduction. This could be done by reducing the size of the bad debt reserve.10The U.S., for example,
in its pre-1986 rules did not require a debt to be overdue in order for the
taxpayer to determine that it is wholly or partly worthless. Regs. 1.166-1 (c)
Other countries like the Czech Republic or Hungary do. European Tax Handbook
142, 284 (2001, IBFD).

NOTE: The series of Tax Law Notes has been prepared by the IMF staff as a resource for use by government officials and members of the public. The notes have not been considered by the IMF Executive Board and, hence, should not be reported or described as representing the views of the IMF or IMF policy.